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Tuesday, October 18, 2011

Short Memories And Temporary Conditions

While there are many who believe market prices accurately reflect all available information, value investors believe there are many instances where market prices can be way out of line with reality. In our society, financial memory appears to be extremely short, causing speculators to fall prey to the same situations over and over. Recent happenings in the rare earths market illustrate this phenomenon very well.

It wasn't long ago that market observers became obsessed with what are called "rare earth metals". These mined elements have applications in cars, televisions, lamps, batteries and all sorts of common goods. The reason for the obsession was the large price spike in the prices of these elements; some of these elements rose in price by ten times over the course of a few weeks!

For some items, price spikes result in very peculiar behaviour. When the price of movie tickets or cars or books goes up, we tend to buy fewer of them. But when price spikes occur in goods like houses, gold, and baseball cards, we as a society seem to want to buy more of these items. We didn't want these items before the price went up, but because the price went up, now we do. Puzzling. In his book examining price bubbles, Vikram Mansharamani borrows from George Soros in calling this 'reflexive' behaviour, and is one of the signs of a bubble.

The price spike in rare earths caused many to load up on rare earths miners and rare earth metals themselves. Since we use these elements every day, fears were emerging that life as we know it was about to change, amid predictions that future supply shortages would be severe.

CNBC offers "Here is the key for investors: Demand will only grow in 2011".

On prices, zerohedge.com argues that "judging by the charts below, the rate is certainly worthy of escape velocity" and "that plasma TV purchase...could end up being costly, after TV producers are forced to double the prices of finished goods."

A number of stock picks were offered on both mass media and the blogosphere. One particularly favoured company appears to be Avalon Rare Metals (AVL), which is now down about 70% from its peak a few months ago.

So what happened? There was a supply and demand response to the ridiculous prices. Rare earth prices have now fallen, and they are predicted to fall considerably further. Buyers, including major car companies, have engineered the expensive metals out, resulting in reduced demand.

This was a particularly quick forming bubble and burst combination. In many cases, however, bubbles form over years. But the result is the same. Supply and demand responds to high prices. For example, if house prices are high, more houses are built. If oil prices are high, more oil exploration takes place. The key for investors is to understand this process and ensure that they don't get pulled into such bubbles (even the ones that last several years!), lest they get stuck holding the bag at the end of the party.